Credit Analysis Models Question Bank

LO.a: Explain probability of default, loss given default, expected loss, and present value of
the expected loss and describe the relative importance of each across the credit spectrum.

1. Which of the following statements is most accurate? The four measures commonly used to
quantify credit risk are:
A. credit spread, risk premium, present value of expected loss and recovery rate.
B. probability of default, loss given default, expected loss, and the present value of
expected loss.
C. recovery rate, loss given default, expected loss and credit spread.

Table 1: Information on three bond issues

Company Probability of Expected Loss Present Value of the Expected
Default (% per year) (dollars per 100 par) Loss (dollars per 100 par)
Ace Corp. 1.25 $25.00 $21.70
Paxton, plc. 0.75 $26.50 $22.00
Bosse Inc. 2.35 $40.00 $35.00

2. Based on the information in Table 1, all else constant which company is most risky in terms
of probability of default and which company is least risky in terms of expected loss?
A. Paxton, Bosse.
B. Bosse, Ace.
C. Bosse, Bosse.

3. The difference in ranking between probability of default and expected loss is due to:
A. discounting.
B. loss given default.
C. time value of money.

4. Based on Table 1, which company is the least risky according to the most preferred measure?
A. Ace.
B. Paxton.
C. Bosse.

LO.b: Explain credit scoring and credit ratings, including why they are called ordinal
rankings.

5. Based on credit scoring, if Borrower X has a credit score of 600, and Borrower Y has a credit
score of 300, then:
A. borrower X is half as likely to default as Borrower Y.
B. as economy deteriorates, Borrower X score changes to reflect the economic state even
if his financial circumstances remain unaffected.
C. borrower X is less likely to default than Borrower Y

6. Credit scores and credit ratings both provide a(n):

A. cardinal ranking of a borrowers credit risk.
B. ordinal ranking of a borrowers credit risk.

Copyright IFT. All rights reserved. Page 1

 Credit Analysis Models Question Bank

C. an estimate of the borrowers default probability.

LO.c: Explain strengths and weaknesses of credit ratings.

7. Regarding credit ratings, which of the following statements is least accurate?

A. Credit ratings tend to be stable over time which reduces volatility in debt market
prices.
B. Credit ratings do not depend on the business cycle.
C. An issuer-pays model does not create an incentive conflict.

LO.d: Explain structural models of corporate credit risk, including why equity can be
viewed as a call option on the companys assets.

8. Which of the following is most likely a characteristic of the structural model?

A. In a structural model, holding the companys stock is comparable to owning a
European call option on the companys assets
B. The structural model implies that the probability of default is equal to the probability
that the equitys value is less than the face value of the debt.
C. In a structural model, owning a companys debt is similar to owning a risk-free zero-
coupon bond and simultaneously buying a European put option on the companys
assets with the same exercise price as the bonds face value.

Table 2: Select information on Company Z

Asset value at time t, At $1,000.
Expected return on assets: u 0.04 per year.
Risk-free rate: r 0.02 per year.
Face value of debt: K $750.
Time to maturity of debt: T-t 1 year.
Asset return volatility: 0.25 per year
Company Z information for credit risk
measures:
N(-d1) 0.0876
N(-d2) 0.1344
N(-e1) 0.0755
N(-e2) 0.1179
Expected loss $9.84
Present value of expected loss $11.20

9. Based on the information in Table 2, using the structural model for credit risk measures, the
probability of default is closest to:
A. 11%.
B. 12%.
C. 10%.

10. Based on the information in Table 2, the value an investor would pay to an insurer to remove
the default risk from holding Company Z bond is closest to:

Copyright IFT. All rights reserved. Page 2

 Credit Analysis Models Question Bank

A. $11.
B. $12.
C. $13.

LO.e: Explain reduced form models of corporate credit risk, including why debt can be
valued as the sum of expected discounted cash flows after adjusting for risk.

11. In reduced form models, the expression for debt price consists of:
A. present value of the recovery rate and loss given default.
B. debts expected discounted payoff of face value given no default and debts expected
discounted payoff if default occurs.
C. functional forms of default intensity and loss given default.

12. Consider the following information of a debt issue of Company P:

Face value, K $700
Time to maturity 1 year
Default intensity, 0.015
Loss given default, 30%
Price of 1-year default-free zero-coupon bond 0.95
Following Credit Measures are calculated using the reduced form model
Probability of default 0.0149
Expected loss $3.143
Present value of the expected loss $2.986
The premium for the risk of credit loss:
A. is dominated by the discount for the time value of money.
B. dominates the discount for the time value of money.
C. is equal to the time value of money discount rate.

13. A credit analyst is calculating the one-year default probability of Company X by using a new
logistic regression model. The table below shows the outputs from running a logistic
regression using only four explanatory variables The coefficients of the model and the inputs
for Company X are given as follows:
Coefficient Coefficient Input Value Input Name
Name Value
Alpha -3 Constant term
b1 0.7 0.063 Unemployment (decimal)
b2 1.2 0.82 Market leverage ratio (decimal)
b3 -3 0.015 Net income/Assets (decimal)
b4 -1 0.055 Cash/Assets (decimal)
Using the logistic function equation and substituting the specific input values (for monthly
observation periods), the monthly default probability for Company X is closest to:
A. 16%.
B. 13%.
C. 11%.

Copyright IFT. All rights reserved. Page 3

 Credit Analysis Models Question Bank

LO f: Explain assumptions, strengths, and weaknesses of both structural and reduced form
models of corporate credit risk.

14. Which of the following is not an assumption of the structural model?

A. Companys assets trade in frictionless arbitrage free markets.
B. The risk free rate of interest is constant over time.
C. The companys assets have a normal distribution with mean u and variance 2.

15. Which of the following is least likely a strength of the structural model?
A. It gives an option analogy for understanding a companys default probability.
B. Current market prices can be used to estimate its value.
C. Credit risk measures can be estimated only by using implicit estimation.

16. Which of the following assumptions is made by structural models but not by reduced from
models?
A. A companys assets trade in frictionless arbitrage free markets.
B. A companys zero-coupon bond trades in frictionless arbitrage free markets.
C. A companys default probability depends on the state of the economy.

17. Which of the following is least likely a strength of the reduced form model?
A. The model uses the hazard rate estimation methodology.
B. The model does not require a specification of the companys balance sheet structure.
C. The models credit risk measures depend upon the state of the business cycle.

LO g: Explain the determinants of the term structure of credit spreads.

18. The credit spread is equal to:

A. difference between the default-free zero-coupon prices and risky coupon prices.
B. the expected percentage loss per year on the risky zero-coupon bond.
C. difference between the yield to maturity of a government coupon bond and the yield
to maturity of a non-investment grade bond.

LO h: Calculate and interpret the present value of the expected loss on a bond over a given
time horizon.

19. France-based, PVX Company promises to pay 30 on 30 April 2018. Today is 30 April 2016.
The risk-free zero-coupon yield on French bonds is 0.45%. PVX credit spread for payment
due 30 April 2018 is 0.25%. All yields and spreads are continuously compounded.
PMT Date Risk- Credit Total Years to Discount Cash Present Risk- Risk-
Free Spread Yield Maturity Factor Flow Value () Free Free
Zero- (%) (%) () Discount Present
Coupon Factor Value ()
Yields
(%)
4/30/2018 0.45 0.25 0.70 2 0.9861 30 29.5830 0.9911 29.7330
Based on the table above, the present value of the expected loss in euros due to credit risk is
closest to?

Copyright IFT. All rights reserved. Page 4

 Credit Analysis Models Question Bank

A. 0.12
B. 0.14
C. 0.15

LO i: Compare the credit analysis required for asset-backed securities to analysis of

corporate debt.

20. When an interest payment is missed, an asset-backed security:

A. goes into default.
B. defaults and causes the SPE to default as well.
C. does not go into default.

21. The credit risk measures for asset-backed securities are similar to those used for corporate
bonds except that:
A. probability of default is not applicable.
B. expected loss is not determined.
C. present value of expected loss is not applicable.

Copyright IFT. All rights reserved. Page 5

 Credit Analysis Models Question Bank

Solutions

1. B is correct. The credit risk measures for fixed-income securities are: the probability of
default, the loss given default, the expected loss, and the present value of the expected loss.
Section 2.

2. B is correct. Bosse has the highest probability of default and Ace has the lowest expected
loss. Section 2.

3. B is correct. The difference between probability of default and expected loss is due to the
loss given default. Expected loss is equal to the probability of default multiplied by the loss
given default. A & C are incorrect because these are modifications required to calculate the
present value of expected loss. Section 2.

4. A is correct. The present value of the expected loss is the preferred measure because it
includes the probability of default, the loss given default, the time value of money, and the
risk premium in its computation. According to the present value of expected loss, Ace is
least risky. Section 2.

5. C is correct. Credit scores provide an ordinal ranking of a borrowers credit risk. The higher
the score, the less risky the borrower. If Borrower X has a higher credit score than Borrower
Y then the interpretation is X is less likely to default than Y, but it does not mean that
Borrower X is half as likely to default as Borrower Y, hence A is incorrect. C is incorrect
because credit scores do not depend on current economic conditions. Section 3.

6. B is correct. Credit scores and credit ranking both give an ordinal ranking, because both
approaches rank borrowers riskiness. They do not provide an estimate of a borrowers or
loans default probability. Probabilities of default provide a cardinal ranking of credit.
Section 3.

7. C is correct. The issuer-pays model for compensating credit-rating agencies has a potential
conflict of interest that may distort the accuracy of credit ratings. Credit rating agencies are
paid by the issuer and consequently have an incentive to give a higher rating than may be
justified. A & B are correct statements regarding credit ratings. Section 3.

8. A is correct. In a structural model the equity holders will pay off the debt at maturity only if
the value of the assets exceed debt at maturity T. If AT is the value of assets and K is the face
value of debt, then payment is only in case of AT K. After the payment, they keep whats
left over (AT K). If AT < K, the equity holders will default on the debt issue. Consequently,
the time T value of the equity is ST = max[AT - K,0]. The companys equity has the same
payoff as a European call option on the companys assets with strike price K and maturity T.
Hence, holding the companys equity is economically equivalent to owning a European call
option on the companys assets. B is incorrect because the probability that the debt defaults is
equal to the probability that the assets value falls below the face value of the debt. C is
incorrect because owning debt is similar to owning a riskless zero-coupon bond and

Copyright IFT. All rights reserved. Page 6

 Credit Analysis Models Question Bank

simultaneously selling a European put option on companys assets with the same exercise
price as bonds face value. Section 4.1.

9. B is correct. ( ) Section 4.3.

10. A is correct. The present value of expected loss

( ) ( )
is: ( ) ( ) ( ) ( ) = ( )
( )
This value is how much an investor would pay to a third party (an insurer) to remove the risk
of default from holding $750 bond. Section 4.3.

11. B is correct. Expression for debt consists of two parts. The first term represents the debts
expected discounted payoff K given that there is no default on the companys debt. The
discount rate [ru + (Xu)] has been increased for the risk of default. The second term on the
represents the debts expected discounted payoff if default occurs. Section 5.1

12. A is correct. The present value of expected loss is less than the expected loss. Hence the
time value of money dominates the risk premium. Section 5.2.

13. C is correct. Using the logistic function:

( ) ( ) ( ) ( ) ( )
Section 5.3.2.

14. C is correct. The correct assumption of the structural model is that the time T value of the
companys assets has a lognormal distribution with mean uT and variance 2T. A & B are
assumptions of the model. Section 4.2.

15. C is correct. For the structural model, one cannot use historical estimation. The reason is that
the companys assets (which include buildings and non-traded investments) do not trade in
frictionless markets. Consequently, the companys asset value is not observable. Because one
cannot observe the companys asset value, one cannot use standard statistics to compute a
mean return or the asset returns standard deviation. This leaves implicit estimation as the
only alternative for the structural model. Credit risk measures are biased because implicit
estimation procedures inherit errors in the models formulation. A & B are structural model
strengths. Section 4.4.

16. A is correct. Reduced form models replace the structural model assumption that the
companys assets trade with a more practical one that some of the companys debt trades.
A represents an assumption made by structural models, but not by reduced form models. B
represents an assumption made by reduced form models. C is not correct because in
structural models, credit risk measures do not explicitly consider the state of the economy.
Sections 4, 5.

17. A is correct. B & C represent strengths of the model. Hazard rate estimation procedures use
past observations to predict the future. For this to be valid, the model must be properly

Copyright IFT. All rights reserved. Page 7

 Credit Analysis Models Question Bank

formulated and back tested. This is a weakness, not a strength, of the reduced form models.
Section 5.3.2.

18. B is correct. There are two ways of looking at credit spread: 1) credit spread is equal to the
difference between the average yields on the risky zero-coupon bond and the riskless zero-
coupon bond; 2) credit spread is equal to the expected percentage loss per year on the risky
zero-coupon bond. Section 6.2.

19. C is correct. The present value of expected loss is given by the present value of riskless cash
flow less the present value of the cash flow with credit risk: 29.7330 29.5830 = 0.15.
Section 6.3.

20. C is correct. Unlike corporate debt, an ABS does not go into default when an interest
payment is missed. A default in the pool of securitized assets does not cause a default to
either the SPE or a bond tranche. Section 7.

21. A is correct. For corporate bonds, credit risk measures are: the probability of default, the loss
given default, the expected loss, and the present value of the expected loss. For asset-backed
securities, the probability of default does not apply, so it is replaced by the probability of
loss. Section 7.

Copyright IFT. All rights reserved. Page 8